Putting on the VIX

ANNANDALE, Va. (MarketWatch) -- One of the explanations I've heard for why the stock market's staged a mid-week recovery last week was that the VIX finally rose above the 30 level.

I'm not buying it.

The VIX is the CBOE's Volatility Index
VIX, -1.44%
which is designed to measure the volatility that options traders are expecting the stock market to experience over the subsequent 30 days. The CBOE employs a complex formula that is based on the assumption that, other things being equal, options will trade for higher prices when expected volatility rises. As a general rule of thumb, the VIX rises as the stock market falls, and vice versa.

And on the surface, it seems plausible that the VIX's rising above 30 did indeed trigger the rally. When the Dow Jones Industrial Average
DJIA, +1.38%
hit its intraday low of 10827.71 on Wednesday, the VIX hit an intraday high at 30.81. Wednesday was the first trading session since mid-March in which the VIX had been above 30.

And just as the VIX's close in mid-March above the 30 level triggered an impressive rally, so did it this past week: By the end of Friday's trading session, the Dow was nearly 700 points higher than where it had stood less than three days previously.

To determine whether the VIX deserves the credit, I loaded into my PC's statistical package the historical data for the VIX back to 1990 (courtesy of the CBOE). On the surface, the data certainly appeared to provide strong support for the notion that a VIX above 30 is a bullish omen.

Consider first how the stock market performed over the subsequent month following a VIX close above 30: On average over the past 18 years, it gained 3.8% (as measured by the Dow Jones Wilshire 5000 index
97199001
). In contrast, the stock market gained just 0.7% over the subsequent month following VIX closes below 30.

Not bad.

Furthermore, similar contrasts existed at the quarter, six-month and 12-month horizons.

Why, then, am I resisting giving credit for this last week's rally to the VIX's close above 30? Because there's a sleight of hand involved in these summary statistics.

After all, there's no way of knowing how high the VIX will rise when it first crosses the 30 threshold. Sometimes, like last week, the stock market immediately rises when that ceiling is broken, leading in most instances to the VIX falling back below 30. On other occasions, however, the stock market continues declining despite the VIX rising above 30, causing the VIX in most cases to continue rising. The all-time high for the VIX is 45.74.

So even though, other things being equal, higher VIX readings are more bullish than lower ones, there's nothing particularly magical about the 30 level.

To correct for this sleight of hand, I focused on just those occasions in which the VIX initially broke the 30 ceiling, after having been below 30 for at least three months previously. The data now painted an entirely different picture: Following those occasions, the stock market on average performed no better than it did the rest of the time.

Is there anything more we can say about the VIX?

Undoubtedly, many of you will try. After previous columns in which I analyzed the VIX, and largely found it wanting as a stock-market-timing indicator, I was inundated by emails disagreeing with me. Those emails proposed any of a number of alternate ways of interpreting the VIX that supposedly are able to withstand statistical scrutiny.

I've tested many of them, and almost all of them came up wanting. I've not changed my mind.

Even in those situations in which the VIX does appear to have statistically significant ability to forecast market movements, it turns out that those abilities largely derive from no special insights on the part of the VIX itself, but instead because of the stock market's tendency to rebound after steep corrections.

I owe this latter insight to Samuel Eisenstadt, research director at Value Line, Inc.
VALU, -6.35%
Eisenstadt several years ago designed an econometric test to see if high VIX readings contain any unusual market-timing information after market declines, above and beyond the already-apparent fact that the market has just fallen. He came away empty-handed. High VIX readings tell us nothing more than we would already know from casually reading the news headlines.

The bottom line? The stock market may indeed continue to rally over the next several weeks. But if it does so, it won't be because the VIX momentarily rose above 30 last week.

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